Wednesday, September 4, 2013

Life is full of trade-offs. One tradeoff includes immediate consumption versus delayed gratification. Essentially, should you save now and bear fruits of your investment 30 years from today or should you spend everything today and rely on pensions and social security later. Both decisions can have impacts on your life, which might not be known for years from now.

Another tradeoff many income investors face is focused on choosing dividend yield and dividend growth. We have similar issues with selecting high yielding stocks today versus selecting high dividend growth stocks which have modest yields today.

On one hand, investors in high yielding stocks are able to generate high dividend incomes on their initial investments. This would allow them to reach the point of financial independence much faster. Investors in higher yielding companies typically spend the dividend checks however, rather than reinvest them.

On the other hand, companies that pay above average yields often do so because their business is not growing quickly. As a result, they pay a large portion of earnings or cash flows to investors in the form of dividend. Since earnings are not rising quickly enough, many high yielding stocks either maintain their dividends flat or increase them barely to keep up with inflation. Utility stocks are a notorious example for this situation. Despite their high current yields, many utilities typically do not grow earnings and dividends above the rate of inflation. Last year, I sold most of my shares in Con Edison (ED), because the dividend had been raised by a mere 1%/year since 1996, which was not enough to keep purchasing power of this dividend income stream. In addition, the low interest rate environment has pushed yields on utilities to levels at which it made sense to switch to other comparable income stocks which offered the possibility for higher dividend growth.

At the same time, dividend growth stocks with more modest current yields are typically purchased by younger investors, who have at least one or two decades before retirement. These stocks are purchased with the intent of holding on and enjoying a rapid growth in dividend income over time. This would be possible from sustained growth in earnings per share, along with a slight expansion in the dividend payout ratio over time, never to exceed 60%. For example, a $1000 investment in a company which yields 2% today but grows distributions by 12%/year, would generate $40 in annual dividend income in 6 years and $160 in annual dividends in 18 years. If the investor also reinvested distributions into more shares, they would be generating an even higher income. In addition to that, a company which yields 2% today would likely yield 2% – 3% in 18 years, assuming that growth rates remain fairly constant. As a result, the rate of increase in the stock price would likely follow the level of increase in earnings and dividends. Our lucky investor would have generated not only a very nice income stream in 18 years, but also pretty sizeable capital gains as well.

On the other hand, maintaining a 12% growth in earnings per share to support a 12% in annual dividend growth is extremely difficult to maintain. Companies can manage to achieve this kind of growth for long periods of time are rare indeed. For example, there are 107 companies in the CCC list maintained by David Fish which have boosted dividends for at least one decade, and have enjoyed annual dividend growth rate of 12%/year. If we require a streak of at least 25 years of consecutive dividend increases however, the number of companies who boosted dividends by 12%/year on average over the preceding decade falls to 28.

The reasons behind decrease in growth are numerous. As companies increase their presence in as many communities as possible, adding extra locations could cannibalize sales from existing locations. In addition, competitors might try to steal market share, or the company could be unable to pass on cost increases to consumers. All those factors and many others could endanger future growth. It is difficult indeed to project historical rates of dividend growth too far in the future.

In my investing I try to focus on companies in the sweet spot, where I get the maximum dividend growth at the maximum possible yield. A few examples include:

McDonald's Corporation (MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. The company has increased distributions for 36 years in a row. Over the past decade, McDonald's has managed to raise distributions by 28.40%/year. Currently, the stock trades at 17.40 times earnings and yields 3.20%. Check my analysis of McDonald's.

Phillip Morris International (PM) is engaged in the manufacture and sale of cigarettes and other tobacco products in markets outside of the United States of America. The company has managed to boost dividends by 13.10%/year since 2008, when it became an independently traded company. Currently, the stock trades at 16.60 times earnings and yields 4%. Check my analysis of PMI.

Kinder Morgan, Inc. (KMI) owns and operates energy transportation and storage assets in the United States and Canada. Since going public in 2011, the general partner of Kinder Morgan Energy Partners and El Paso Pipeline Partners has increased dividends by 33%. Furthermore, low double digit distributions growth is expected for the next few years. At a current yield of 4.30%, Kinder Morgan looks like a great yield play with a high dividend growth kicker.

I am fairly new, but very excited to learn about investing in the tried and true companies as referenced by Jeremy Siegel and like you reference in your blogs.

I have had some trouble understanding how KMI is a good buy when their P/E ratio is so high. Would the expected future growth (i.e. PEG ratio) be the overriding factor in ignoring their P/E ratio?

Some types of entities, like REITs, are different in that the P/E ratio is not as important. However, based on KMI's structure, it seems the the P/E ratio would be important, so I am a little confused as to why KMI is such a popular buy and their price to be considered a current good value.

Thank you DGI... Keep up the good work! Your blog is an asset to many...

In keeping with the dividend growth discussion, including a long time horizon, what are your thoughts on Visa? The debit fee fiasco may present a great buying opportunity. The dividend growth is remarkable the last few years with the payout ratio remaining very low. Thank you for your response!

I currently take a more balanced approach. Mine main focus is on finding solid strong companies with history of dividend growth. I have some high yielding slow growers and some lower yielding high growers in my portfolio currently. As I reach the point where I will need the income to live off of I will probably try shifting my portfolio more towards higher yielding securities but make sure that it is not at the expense of owning lower quality companies.

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